Import Substitution, Export Promotion, and the Role of the State in Economic Development

Import Substitution, Export Promotion, and the State in Economic Development
Author(s): Richard Grabowski

Source: The Journal of Developing Areas, Vol. 28, No. 4 (Jul., 1994), pp. 535-554
Published by: College of Business, Tennessee State University
Stable URL: http://www.jstor.org/stable/4192386
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The Journal of Developing Areas 28 (July 1994) 535-554
Import Substitution, Export Promotion,

and the State in Economic Development
RICHARD GRABOWSKI
Development economics has been subject to significant shifts in viewpoint

concerning the role of trade in economic development. After World War II there
was a general pessimism with respect to the potential of trade to promote rapid
growth. ' Alternatively, there was a general optimism with respect to the capabilities
of the state to carry out effective development policy. Out of these views evolved
the import-substitution strategy of economic development.2 It involved utilizing
a variety of policy instruments (tariffs, quotas, and subsidies) to protect the
domestic market for many types of manufactured goods. Thus the incentive to
produce for the domestic market was increased relative to the incentive to export.
All of this involved a significant role for government policy making.
Difficulties encountered in the pursuit of import substitution as well as
additional theoretical work led to a critical reevaluation of this approach. The
result was the evolution of an outward-oriented strategy of development.3 This
perspective was generally very optimistic concerning the positive role that trade,
in particular export expansion, could play in overall development. At the same
time, proponents of this viewpoint were very pessimistic concerning the ability
of the state to carry out effective policy. Thus the state should refrain from
interfering with trade, and incentives to producers for production aimed at the
domestic market versus foreign markets should be neutral or unbiased in nature.
These two strategies have often been viewed as opposites or completely separate
theoretical categories. This paper will argue that they are not opposites, but simply
alternative ways for stimulating the growth in the size of markets for manufactured
goods. It is the latter that is crucial in the process by which late-developing nations
Professor, Department of Economics, Southern Illinois University-Carbondale, Carbondale, IL

6290 1-45 15.
This paper was written while the author was a Visiting Fellow at the Institute of Development Studies,
University of Sussex, Brighton, England.
? 1994 by Western Illinois University. All rights reserved.
536 Richard Grabowski
can adapt and learn the new technologies necessary to rapidly increase productivity.
It will be contended that import substitution is generally necessary for outward-
oriented growth to succeed. More important, the success of import substitution is
linked to the development of productivity in the agricultural sector. If the latter
fails to grow rapidly, import substitution will fail and successful export-based
growth will not occur. In this scenario the state will generally behave in a
predatory manner with respect to the economy. Alternatively, if productivity in
the agricultural sector is rapidly growing, the strategy of import-substitution
industrialization will likely succeed, the state will generally behave so as to
promote productivity growth, and outward-oriented growth will likely succeed.
The first two sections of the paper will review respectively the salient features
of import substitution and outward-oriented or export-based development. The
third section will present an alternative perspective based on technological
learning and its dependence on the rate of growth of the market. Arguments will
be presented there concerning why import substitution will generally precede
outward-oriented growth. In addition, agriculture's role in this process is explored.
The fourth section will discuss the relationship between market growth and state
behavior. The experiences of Japan and, to a much lesser extent, Taiwan and
South Korea, are briefly reviewed in the fifth section to illustrate the ideas
developed in the paper. Finally, the sixth section will summarize the paper.
Import Substitution and Development
Import-substitution strategies of economic development have generally used

tariffs, quotas, and the exchange rate to promote domestic industrialization by
allocating resources away from export-good production and toward production
for the domestic market. Tariffs and quotas protect domestic producers from
foreign competition while an overvalued exchange rate cheapens imported
capital goods for use in the domestic industrialization process. Of course, this will
generally result in a foreign exchange shortage that requires the implementation
of various control schemes to allocate scarce foreign exchange.4
Import-substitution strategies have been justified on a number of grounds.
Export pessimism has provided one such rationale. Given the low price and
income elasticities of demand for the primary products produced by most less
developed nations, export revenue is likely to grow slowly, if at all.5 Thus, if
industrialization is to proceed, it must be on the basis of the domestic market,
rather than foreign markets.
Often the existence of price distortions has also been used as ajustification for
import substitution. A simple example of this is provided in Lewis's model of
economic development with surplus labor.6 Remember that in this model labor in
the traditional sector is paid a wage that is above its marginal product. One can
think of a peasant family that divides the output of the farm equally among all
members. The wage in the traditional sector is the opportunity cost of labor for
the modern industrial sector. The latter hires labor up to the point where the
Import Substitution, Export Promotion, and the State 537
marginal product of labor in industry is equal to the wage rate, as determined in

the traditional sector.
The difficulty with the preceding situation is that employers in the modem
sector have to attract workers from the traditional sector by paying a wage at least
equal to and probably greater than that which labor can earn in the traditional
sector. Labor in the latter sector, however, earns its average product, which
exceeds its marginal product (the social opportunity cost of labor). Thus, because
the wage rate exceeds the social opportunity cost of labor, too little of the latter
will be hired by the modern industrial sector, and the level of production in this
sector will be too small.
If the foregoing is true, then the solution is for the state to step in to promote
the expansion of the modern relative to the traditional sector, a policy that would
result in a transfer of labor from the traditional to the modern. The state could
achieve this goal by using tariffs and quotas to raise the return to capital in the
modern sector, which would in turn lead to increased employment and production
in this sector.
Anotherjustification sometimes offered involves the existence of externalities.
These externalities are thought to arise in a number of ways. For example, if firms
expend resources to improve the productivity of their workers, they hope to reap
the benefits of such productivity improvements through the future activities of the
workers in their firms. If the worker leaves the firm, however, then these potential
benefits are lost and the firm is left with bearing the cost. As a result, firms are
likely to underinvest in the improvement of human capital. Thus, protection of
industry will encourage the protected firms to expand production and expenditures
related to growth, including expenditures on training.7
The most common justification for protection is, of course, the infant industry
argument. The notion is a very simple concept. Less developed nations establishing
new or infant industries will find that they are unable to compete successfully
against similar industries in already-developed nations. Often this is explained by
reference to economies of scale. Initially infant industries operate at such a small
scale that per unit costs are extremely high and thus a price that covers such costs
will be high relative to industries in developed countries operating at a large
enough scale such that per unit costs are low. In order to overcome this difficulty,
the infant industry must be temporarily protected until it can attain an efficient
scale of operation.
Note that all of the preceding arguments or justifications are pessimistic in
their view of how markets operate, but implicitly optimistic concerning the
government's ability to solve problems. Also, protection in the form of quotas and
tariffs can be, at most, a second-best solution to the problems involved. The best
solution would be to intervene at the source of the problem directly. Specifically,
"it is usually more efficient to use those policy instruments that are closest to the
source of the distortions separating private and social benefits and costs."8
The application of the foregoing rule to the price distortion in the Lewis model
would involve the state's subsidizing the employment of labor in the modern
sector rather than protecting this sector. The former is less costly than the latter
since prices to consumers are not increased. In terms of the externalities to worker
training, it would be less costly for the state to directly subsidize such training
rather than to protect domestic industry. Again, the latter course involves a cost
to consumers whereas the former does not. Finally, with respect to the economies-
of-scale argument, the real problem is that the capital market is not operating
properly. Thus, a better solution would be for the state to foster the development
of a capital market.
Although the preceding arguments are theoretically correct, the point is often
made that the best policy solutions are, in terms of transaction costs, too costly to
carry out. The ability to allocate subsidies and construct capital markets requires
skills and abilities beyond the administrative capacity ofmost developing nations.
It follows that although tariffs and quotas may not be first best solutions to market
problems, they are the only ones that can be effectively implemented. Thus, the
first best issue is ignored from this point on.
A different sort of criticism of the import-substitution approach, however,
cannot be ignored. The view taken earlier of the efficacy of government policy
making ignores the very real possibility of government failure.9 That is,
governments, in an attempt to deal with perceived market failure, may impose an
even greater cost on the economy in attempting to deal with such failures. This
may be the result of the ineptitude of government bureaucrats, the effects of the
influence of powerful interest groups, or the willingness of government leaders
and employees to substitute their own private interests and goals for those of
society.
In fact, the experiences of many developing nations would seem to support the
foregoing view. Infant industries have had a tendency never to grow up. In
addition, import-substitution policies accompanied by exchange controls have
tended to promote the use of more capital-intensive techniques of production. The
exchange controls themselves have resulted in a vast increase in the rent-seeking
activities of private interest groups, dramatically increasing the costs of
protection. 10
The problems just discussed were most apparent in second-stage import
substitution rather than first-stage import substitution. In the latter, the key
industries involved are simple, more labor-intensive goods such as textiles,
footwear, and food processing. Alternatively, in the former, the key industries
involve consumer durables and intermediate and capital goods, all of which are
more capital intensive and technologically complex.
With the apparent failure of import substitution, the alternative of outward-
oriented development moved to the forefront. This alternative will be discussed
in the next section.
Export-Based or Outward-Oriented Development
The export-based or outward-oriented strategy of development has been

subject to some confusion of definition. The term itself seems to imply, at first
glance, a preference for production for foreign relative to domestic markets. For
most analysts, however, this strategy involves a neutral perspective. That is, the
bias of import substitution for domestic-market production should be removed so
that incentives for foreign versus domestic production are neutral in nature."
The benefits or returns to such a strategy are thought to be both numerous and
widespread. Of course, trade according to the principle of comparative advantage
yields increased efficiency in terms of resource allocation. These efficiency gains
are augmented by the ability of trade to curb the economic power of oligopolies
and monopolies. This ability also improves the allocation of resources. These
allocational gains are what are sacrificed when governments seek to protect
domestic industries.
Another gain from an outward-oriented strategy involves the economies-of-
scale issue. Remember that advocates of import substitution have appealed to this
concept to justify temporary protection of an industry. Proponents of an export-
based strategy argue that domestic markets are too small to allow firms to achieve
optimal scale. It is through production for sale to foreign markets that firms can
achieve increasing returns and, eventually, optimal scale.'2
The arguments just presented are comparative static, efficiency arguments for
free trade or outward-oriented development. They imply that once a country
follows such a strategy there will be one-time overall gains in efficiency. They do
not seem to imply, however, that outward-oriented strategies will have any
dynamic effects. That is, the preceding arguments do not imply that the rate of
growth can be raised by such a strategy. There are some additional gains from
trade that may be more dynamic in nature.
Deepak Lal and Sarath Rajapatirana have argued that the entrepreneur is the
key to rapid growth.'3 They hold that economic decision making involving
possible future events (investment and innovation) is subject to ignorance, not
risk. Risk occurs when it is possible to attribute probabilities to the occurrence of
certain results, and thus firms can maximize expected profit. In this context the
entrepreneur has no role to play. In situations characterized by ignorance, such
probabilities cannot be attributed to various future alternatives. In fact, the future
possibilities from investment and innovation are not even known. It is in this
situation that the entrepreneur takes on a key role. He must search out investment
opportunities and gamble on a future that is unknowable.
Lal and Rajapatirana argue that an outward-oriented strategy of development
provides greater opportunities and rewards for such entrepreneurial activity.
With an import-substitution strategy governments are free to engage in policies
that can distort the domestic economy in an attempt to guarantee the availability
of the domestic market for domestic producers. In a free-trade environment,
however, the options that the government has at its disposal are limited. That is,
the government is not capable of assuring domestic producers access to export
markets except through the use of direct subsidies. These must come directly from
the government budget and are not as well hidden as the subsidies provided
through import-substitution strategies. Thus, activities by the state aimed at
distorting the market are likely to be restricted in an outward-oriented strategy of
development. Growth is likely to be higher as entrepreneurial activities become
more intense.
Another possible dynamic impact of an outward-oriented strategy relates to

the ability to import. Since most modem technologies are embodied in capital
equipment that cannot be produced in less developed nations, imports of such
materials will have to be relied upon. Therefore, the rate at which new technology
can be applied will depend on the capability to import. The faster exports grow,
the more rapidly new technology embodied in foreign-produced capital can be
imported. Thus, the overall rate of growth is likely to be increased as the rate of
technical innovation increases.
The outward-oriented approach has not been free of criticism. Any individual
less developed nation could certainly embark upon an outward-oriented strategy.
However, if all, or at least a large number, of less developed nations embarked
upon such a strategy, this activity would certainly dramatically increase the
penetration of the developed countries' markets, especially for manufactured
goods. One would think that this would certainly lead the already-developed
nations to seek to protect their markets from such a deluge. Thus, what might be
possible for one or a few less developed nations may not be possible for the group
in general.'4
Another line of criticism concerns the pessimistic view of the state put forward
by the proponents of outward-oriented development. The state is seen as predatory
in nature, pursuing the interests of the elite or the bureaucracy or both at the
expense of society in general. Now, no one would deny that there is much
evidence to support this view; however, the experiences of a number of countries
indicate that this need not be the case. A more general view of state behavior
requires a more general v-iew of individual behavior.
It is usually assumed that individual choice is dominated by self-interest, even
if this interest conflicts with that of the group or society (illustrated in simple
prisoners' dilemma games). Douglass North, however, sees individual behavior
as being constrained by a number of factors other than the budget. Specifically,
there are formal and informal rules operating through the social infrastructure as
well as self-imposed codes of behavior that limit maximizing behavior. North
contends that these constraints are more likely to be obeyed if the cost of doing
so is relatively low. More simply, he sees a situation in which "the lower the cost
of expressing one's convictions the more important will the convictions be as a
determinant of choice.""5
This perspective is a more fruitful view in that it allows one to analyze why
some governments and bureaucracies seem to behave with the interests of society
in mind while others do not. In addition, it provides a mechanism through which
an explanation can be made as to how states and their bureaucracies evolved into
what they are in many less developed nations. These ideas will be further
developed later in the paper.
A third line of criticism concerns the view of technology and its transfer. As
has been noted by Howard Pack and Larry E. Westphal, "Technology is charac-
terized by a considerable element of tacitness, difficulties in imitation and
teaching, and uncertainty regarding what modifications will work and what will
not."' 6 In other words, it is impossible to master a particular technology appropriate
to particular circumstances without actually applying it. Thus the learning of a

technology comes only from experience with its use. How is a firm to gain such
experience in production if it cannot compete with foreign suppliers of the good?
It would seem, then, that import substitution through protection may be a
necessary first step in the process of development. These ideas are further
developed in the next section of the paper.
An Alternative Perspective of Development Based on Technological

Learning
At the beginning of this paper it was argued that import substitution and
outward-oriented growth are not two opposing categories of thought, but instead
are two complementary ways of achieving the same goal. The goal is to catch up
with the developed world. All less developed nations find themselves behind in
terms of technology. In other words, most less developed countries are operating
inside the production possibilities curve. This backwardness is compounded by
the fact that technical innovation in the developed nations is pushing the
technological frontier outward at a rapid rate. Thus, development involves
closing the gap with this frontier over time.
In order to close the gap new technologies must not only be imported, but they
must also be learned. As pointed out earlier, this learning must be done through
the experience of actual production. It is only through this means that the costs
of production can be lowered, and it is only in this way that the new technology
can be adapted to the indigenous circumstances. The latter process may itself
involve a series of small innovations that over time is likely to result in substantial
cost savings.
The process of learning just discussed is likely to be more rapid the more
rapidly the market demand for particular manufactured goods is growing. Alice
H. Amsden has highlighted this process in her analysis of productivity growth in
late industrialization.'7 Basically, she argues that the neoclassical growth model
is of relatively little use. It posits that the rate of growth is dependent on the rates
of growth of inputs and the rate of technical change. For late developing nations,
however, this is for the most part irrelevant. Productivity increases in such
countries come from importing foreign technology, operating such technology on
a sufficient scale to reduce per unit costs, and learning how to use the foreign
technology. She further suggests that all three of these "are collapsible into one
variable, the growth rate of output."18
If much of foreign technology is embodied in plant and equipment, then the
growth of productivity will be to some extent dependent on the rate of investment
in new plant and equipment. The faster output is growing, the more rapidly
investment is likely to increase, leading to a greater availability of new technology.
In a similar vein, the achievement of economies of scale requires a large market.
The faster the latter grows, the more rapidly economies of scale can be realized.'9
The third mechanism by which productivity can be increased is through the
learning of new technologies through experience. This differs from the economies-
of-scale argument. The latter involves moving down a long-run average cost
curve as the size of market grows. Learning through experience involves the
shifting of the long-run average cost curve downward through time. The faster the
demand for a particular product is growing, the more rapidly experience can be
accumulated.20
Thus, for Amsden productivity depends upon the growth of the market
(demand). In this context both import substitution and outward-oriented growth
(exports) are two different mechanisms for achieving a rapid growth in market
size. The former does this by protecting the domestic market for selected
industries. This allows demand for these industries to grow faster than domestic
consumption, owing to the fact that imports of the particular product are being
replaced with domestic production. Outward-oriented growth is another
mechanism through which demand for specific industries can grow faster than
domestic consumption. Both ofthese mechanisms allow for more rapid productivity
growth through greater investment (embodying new technology), increasing
returns to scale, and learning through experience.2'
It seems rather straightforward, however, that for most industries the import-
substitution phase is likely to precede the outward-oriented development stage.
Before the former has occurred, the per unit costs of production for selected
industries in a less developed country are likely to be much higher than that for
producers in the developed nations. This would be the result of the fact that in the
less developed nation little specialization has occurred and little investment in
and learning about more up-to-date technologies has taken place. Thus, it would
be impossible to begin production for foreign markets without going through an
import-substitution preliminary stage.
Moreover, the difficulties alluded to in the previous paragraph are not just
those of cost. A major difficulty with trying to sell to foreign markets often
involves quality problems. The commodity can be produced at competitive cost,
but the quality is not sufficiently high to allow the penetration of foreign
markets.22 Therefore, production for the domestic market is likely to be required
in order to attain the quality level necessary for successful exporting of the
commodity.
That domestic demand and import substitution are important in the first stages
of industrialization, with exports becoming important only later on, is supported
by the empirical work of Yuji Kubo, Jaime DeMelo, and Sherman Robinson.23
They focus on the sources of growth on the demand side for a number of countries:
Colombia, Mexico, Turkey, Yugoslavia, Japan, South Korea, Taiwan, Israel, and
Norway. They decompose the change in a country's output through time into that
resulting from domestic-demand expansion, export expansion, import substitution,
and changes in input-output coefficients. The last factor represents demand
changes arising from technical change as well as substitution among various
inputs. The results indicate that for most of the covered time periods (varying by
country), domestic demand dominated the growth process in all of these countries.
More important, import substitution dominated export expansion as a source of
growth in earlier time periods. Even for South Korea and Taiwan, the most
discussed of the outward-oriented nations, export expansion was dominated by
domestic demand and import substitution as sources of growth in the 1 950s and
1 960s. Only in the later 1 960s and early 1 970s did export expansion become the
dominant source of growth in these countries.
In the preceding discussion, it has been argued that import substitution may be
the mechanism for rapid market growth initially so that costs can be reduced and
quality improved. This would then allow, at a later stage, the sale of the specific
commodity to foreign consumers via export. Work by Amsden, however, seems
to indicate that penetration of foreign markets utilizing modem technology may
be difficult even after an import-substitution phase and even for commodities that
are relatively labor intensive.24 She points out that in South Korea, it was difficult
even for the textile industry to begin exporting after the first phase of import
substitution. In fact, export subsidies had to be provided initially in order to allow
firms to begin to export profitably commodities that are relatively labor intensive.
Thus, an import-substitution phase may have to be followed by an export-
substitution phase (where exports are actually subsidized) before government
intervention can be eliminated. This is likely to be more relevant the later the
nation begins its industrialization phase, since the technological frontier for even
labor-intensive goods will have shifted even further.
Although several nations, in particular Taiwan and South Korea, have
successfully completed the transition to outward-oriented development via import
substitution, the question remains as to why most less developed nations have
failed to make this transition. In fact, most of these nations having completed the
initial import-substitution stage involving simple, labor-intensive manufactured
goods have instead turned to further import substitution (intermediate and capital
goods) rather than to outward-oriented growth.25 The difficulties of making this
transition seem to be enormous. What exactly are they?
If the reader will recall, the key to economic development for late-developing
nations is to catch up with the technological frontier for, at least initially,
manufactured consumer goods. The frontier is itself shifting out as the result of
technical innovation in the developed countries. Moreover, remember that the
ability to catch up was seen to be dependent on the rate of growth of the market
(demand) for the specific products involved. It is this growth that allows
investment in new capital, specialization, and, most important, acquisition of the
experience necessary to learn new technologies. The more rapidly such demand
grows, the faster the technological gap can be reduced. As this occurs, per unit
costs will fall and quality will rise through time.
The main difficulty seeming to plague this process would appear to be related
to the rate of growth of demand via import substitution. If the domestic market is
small and, more important, if it is growing relatively slowly, then specialization,
investment, and learning may not occur rapidly enough to close the gap with the
technological frontier. Thus, instead of catching up, the country finds itself
falling increasingly behind.
Alternatively, the sluggish growth in the domestic market (demand) may only
allow a nation to partly close the technology gap. Therefore, although productivity
has improved relative to the frontier, the per unit cost and quality differences with
the frontier are still very large. Exporting this particular commodity will remain
impossible unless some form of export subsidies are provided. The greater the
gap, in cost and quality, between current practice in the industry in the less
developed country and the technological frontier, the larger the export subsidy
would have to be. Therefore, the difficulty of making the transition from import
substitution to outward-oriented growth depends on the rapidity with which
domestic demand grows. The faster this is, the lower the cost of transition and vice
versa.
What is the determinant of the growth of the market in many less developed
nations? The agricultural sector appears to play the key role. The more productive
this sector is, the larger the potential market for domestically produced goods.
More important, the faster productivity in agriculture grows, the more rapidly
potential demand for domestic manufacturing increases. If agriculture stagnates,
then markets grow very slowly and technology gaps remain large or increase.
Of course, there is an additional factor that is likely to play a significant role.
It is not just the growth of productivity and incomes in agriculture that is of
consequence. It is the degree of inequality with which this income is distributed
that is also important. As both Robert Baldwin26 and North27 have argued, extreme
inequality in the distribution of income can lead to a demand structure oriented
toward luxury goods that may be difficult if not impossible to produce in a less
developed country. Therefore, a large market for relatively simple manufactured
goods may not develop. A modem version of the foregoing analysis is provided
by the work of Kevin Murphy, Andrei Shleifer, and Robert Vishny.28 Thus, the
growth in demand that will allow selected industries within a less developed
nation to close the technological gap must be broadly based in nature.
Agriculture may not be the only possible source for a rapidly growing potential
market. The country may possess a natural comparative advantage in a labor-
intensive manufactured good. In this case the production of this good for export
would allow for a rapid growth in demand, thus providing an environment in
which other industries, via import substitution, could close the technological gap
and eventually make the transition to outward-oriented growth. The possibility of
this avenue will, of course, vary dramatically from nation to nation. Amsden, as
pointed out earlier, casts doubt upon this possibility.
In summary, only a few less developed nations have made the transition from
import substitution to export-based growth. The main difficulty in making this
transition is, as argued previously, the rate of growth of the domestic market,
which is itself dependent in many circumstances on the dynamism of agriculture.
Where import substitution has failed, its lack of success has been the result of
sluggish growth in domestic demand arising from sluggish growth in the
agricultural sector. Up to this point the government's effectiveness in carrying
out policy has been ignored. It is to this issue that I now turn.
The Relationship between Market Growth and State Behavior
That the government must play a crucial role in the development process is not
in doubt. Historically, as Dieter Senghaas has pointed out, all of today's developed
nations began as late developers with respect to England.29 All of them used
various sorts of protectionist measures to allow selected industries rapidly to
accumulate capital, specialize, and learn to use new technologies by taking
advantage of fast-growing domestic markets. In more recent times a number of
East Asian countries (Japan, Taiwan, South Korea) have also successfully used
import substitution as a springboard to outward-oriented growth. The latter
countries have also been found to have governments that are highly effective for
carrying out government policy. The determinants of this effectiveness in carrying
out government policy will now be explored.
Amsden has pointed out the essential difference between governments that are
effective and those that are not effective in carrying out government policy.30
Effectiveness does not hinge on the giving or not giving of subsidies to selected
industries because all governments do this. Instead, it depends upon the principles
that govern the allocation of subsidies. In countries that have failed to make the
transition from import substitution to export-oriented growth, no performance
standards have been imposed upon the recipients of subsidy. Import-substitution
strategies are indeed methods for granting subsidies. If no discipline is imposed
upon the recipients of such subsidies, than those industries receiving them are
unlikely to become efficient and productive by intemational standards.
The same argument applies to export subsidies. In the previous section, it was
argued that the pursuit of import substitution in a particular industry may still
result in per unit domestic costs of production being higher than per unit costs for
foreign producers. Thus, to export will require a subsidy. If no performance
standards are applied to the recipient, however, then the subsidy may be wasted.
Countries that have successfully made the transition to outward-oriented
growth have disciplined subsidy recipients. "What accounts for differences in
rates of growth of industrial output and productivity among late-industrializing
countries is not the degree to which the state has disciplined labor but the degree
to which it has been willing and able to discipline capital."'" The East Asian
governments have demonstrated this willingness and attained this ability while
governments in most other less developed countries have not. How does one
account for this capability?
At the end of the second section, it was contended that the view of the state elite
and bureaucrats in less developed nations as pursuing their own interests or the
interests of the powerful to the exclusion of society's interests is much too
narrow. The idea put forward there was that individuals would put the interests
of the group above their own as long as the cost is not too high. North argued that
as such costs increase the willingness to sacrifice for the group declines.32
The preceding analysis is very relevant, I believe, to understanding a
government's willingness to discipline firms that are receiving aid (via import
substitution or export subsidy). These firms are likely to try to use their political
clout to force the government to provide the subsidy regardless of performance.
Thus it might well be politically costly for the bureaucratic elite to try to impose
performance standards on these firms. These costs, however, will be dramatically
reduced in the eyes of policymakers if such standards have a high probability of
succeeding in the promotion of rapid productivity growth and eventually rapid

export expansion. The likelihood of this occurring is, as argued in the previous
section, dependent on the rate of growth of the domestic market, which is in turn
dependent (in most cases) on rapid increase in agricultural productivity. Where
this is taking place, the governmental and bureaucratic elite will correctly
perceive that the probability of success through import substitution is quite high
and therefore the political costs of imposing performance standards are much
reduced.
Amsden has made the following argument. "The higher the probability that
investments in industrial development will generate positive returns (in terms of
profitability, or at least employment at break-even costs), the greater the likelihood
that governments will become developmental."33 Conversely, the less likely such
investments will be successful, the more likely the government will remain
nondevelopmental. The previous analysis provides an explanation for this predicted
behavior.
The effectiveness of government policy also depends upon the credibility of
govemment threats to remove subsidies. If firms do not believe govemment
threats, then they will not respond to them. Moreover, if the threats are accurately
assessed as being noncredible, it is highly unlikely that governments will actually
ever follow through with them. The credibility of government threats is arguably
dependent to some extent on the rapid growth ofthe domestic market.34 Presumably,
the government's goal in using an import-substitution strategy of allocating
subsidies is to establish and promote domestic industrial expansion. If domestic
market growth is very slow, then protected firms will not be able to close the
technological gap between themselves and similar industries in the developed
world. Therefore, costs per unit are not likely to fall nor quality of the product to
improve rapidly enough to allow the domestic producer to become competitive
internationally. Thus, if the government should withdraw the subsidies that it
provides to any particular firm or industry, domestic production will cease. The
government could allocate that subsidy (protection) to a different firm or industry
and industrial production would expand there, but once again when the protection
was withdrawn, the industry would fail.
In the preceding situation, the threat to punish industries or firms for not
becoming competitive is not really credible, for what is the alternative? The
withdrawal of the subsidy presupposes that the government can find a use for it
that would indeed be productive. If the domestic market is not rapidly growing,
however, then there may be no productive alternatives available to the government.
Thus, what would be the point of actually withdrawing support from a particular
industry or firm?
Related to the foregoing analysis is the responsiveness of industry to threats to
withdraw protection. The firm that receives a subsidy must decide whether to
invest it in the future productivity of the firm or to use it in an unproductive
manner (raising salaries, lobbying govemment to continue protection, etc.). In
making its decision, the firm must weigh the short-run gains resulting from using
the subsidy to say raise salaries versus the long-run cost occurring if the
government punishes unproductive use of the subsidy by withdrawing it. If the

domestic market is growing only slowly, however, the returns to productively
using the subsidies provided by protection are likely to be relatively low.
Therefore, the firm, in response to government threats to withdraw protection if
subsidies are not used productively, is more likely to ignore such threats and to
use the subsidy in an unproductive manner. In other words, the lower the return
to cooperating with the government (through productive investment) relative to
not cooperating with the government (through unproductive use of a subsidy), the
less cooperation will occur.
The growth of the domestic market influences the effectiveness of the
government in one last way. If the reader will remember, when the domestic
market is growing rapidly, per unit costs are likely to fall and quality to rise at a
rapid enough rate either to allow export when the domestic market is exhausted
or to allow export with a relatively small export subsidy. Thus, the transition to
outward-oriented growth occurs automatically or as the result of a small export-
promoting subsidy. Over time the need for the latter is likely to disappear as rapid
growth in demand stemming from exports will allow the cost reductions and
quality improvements necessary to export unaided by the government.
On the other hand, if the domestic market grows only slowly through time, then
the difference between the per unit costs and the quality of the output of the
domestic firms relative to foreign firms on the technological frontier is likely to
be large and possibly growing. Thus the protection (subsidy) necessary to
maintain domestic production or the export subsidy required to allow the domestic
firms to successfully export the product is likely to be quite large and costly.
The two situations just outlined are likely to have different implications for
generating rent-seeking activities upon the part of individuals and groups within
society.35 Of course, rents are returns to a resource owner in excess of opportunity
costs. Individuals and groups seeking such rents can have a productive effect on
an economy. The best example would be the application of a new technology to
the production process. In addition, in an imperfect world in which the conditions
of perfect competition are not possible, then rent seeking in one area may offset
market distortions in another area resulting in an improvement in overall
productivity. Alternatively, individuals and groups pursuing rents can also
reduce productivity in society. As states protect selected industries in order to
promote industrial expansion, private interest groups benefiting from this action
are likely to expend resources to convince the government to continue protection
in the long run, irrespective of the industry's performance.
It is the unproductive pursuit of rents that are created by government policies
aimed at subsidizing selected industries (via import substitution or export subsidy)
that is the concern here. What is likely to determine the extent to which rent-
seeking activities are likely to surround such attempts at industrialization? It
would seem that the extent of such rent seeking is likely to be positively linked
to the size of the potential rents to be captured. Very high rents are likely to lead
to significant efforts to capture them, and once captured, they are likely to lead
to significant efforts to retain them. Therefore, a large subsidy, via import
substitution or direct export subsidy, is likely to lead to powerful efforts by the

recipients to persuade or force the government to maintain the subsidy. Thus, it
is highly unlikely the gains from such subsidy will be used productively.
Alternatively, if the subsidies necessary to promote domestic industry are relatively
small, there is likely to be less rent seeking surrounding them. It is more likely that
such subsidies will be used productively.
The preceding analysis is, of course, directly connected to the results of the
previous section of this paper. There it was argued that the probability of
successfully making the transition from production for the domestic market to
production for foreign markets is dependent on how rapidly the domestic market
is growing. Rapid growth will allow rapid productivity increases through new
investment, specialization, and learning from experience. Thus, the gap between
per unit costs and quality of locally produced goods and the goods produced in
developed countries is likely to decrease rapidly. Once the domestic market has
been saturated by domestic production, firms' per unit costs may be low enough
and quality high enough that the transition to export can be made with either no
further subsidy or a relatively small one. Therefore, the extent of rent-seeking
activity aimed at the government is likely to be small.
Alternatively, in countries where the domestic market is growing relatively
slowly the technological gap may still be wide and increasing. Thus, the difference
between per unit costs and quality of domestically produced relative to foreign-
produced goods is likely to be very large. The potential rents to be earned from
government protection via import substitution or government efforts to promote
exports via direct subsidy would be significant. This would lead to intensive rent-
seeking activities by private interest groups to attain and maintain such rents.
Therefore, the government is likely to be under intense pressure from such
groups.
The implication of the preceding analysis is that in those countries where
domestic demand is growing rapidly, governments are likely to be under less
intense pressure from special interest groups while the reverse holds when
demand is growing slowly. In the former case, governments would probably be
more successful in imposing performance standards on industries receiving
government subsidy than in the latter case.
In summary, the analyses in the third and fourth sections are closely linked. A
dynamic agricultural sector is likely to provide the framework within which
governments can successfully discipline firms in the promotion of industrialization
and make the transition to outward-oriented growth. In those economies where
agriculture is stagnant, it is highly improbable that successful industrialization
will result from government policy and it is highly unlikely that a transition to the
successful export of manufactured goods will take place. Therefore, the export
pessimism expressed by political leaders and policymakers in the 1950s and
1 960s may not have been so wrongheaded. The prospects for successful transition
to outward-oriented growth were quite dim for those newly independent nations
inheriting stagnant agricultural sectors.
The Relationship between Market Growth and State Behavior: Japan
One objection raised to the preceding analysis might concern the direction of
causality that is implied. Specifically, it is argued that (in many, but not all
circumstances) it is the rapid growth of the agricultural sector that fosters rapid
growth in the domestic market, which in turn provides conditions conducive to
the successful transition to outward-oriented development via effective government
policy. One might, of course, hold that the causality actually runs from the
effectiveness of the state to agricultural and eventually industrial success. In
other words, a strong and effective state is a necessary prerequisite for economic
success. Of course, a more general view would point out that causality probably
runs both ways. However, I would argue that certain historical cases would seem
to provide evidence for causality running from a dynamic agricultural sector to
an effective state. Although space limitations prevent a complete exploration of
this issue, I shall attempt to briefly sketch the outlines of a particular case in what
follows.
In Japan, prosperity in the agricultural sector preceded industrial development
and also preceded the development of the strong state during the Meiji period. I
shall use this as an example of the causation outlined in this paper that runs from
agricultural development to a rapid growth in markets, to effective states, to
successful transition from inward- to outward-oriented development.
Many analysts have marked the beginning of Japanese development as
corresponding to the Meiji restoration (1868). Agricultural productivity, however,
had been growing throughout the previous Tokugawa period (1600-1868).
Although quantitative data for this period is scarce, Susan B. Hanley and Kozo
Yamamura have calculated that rice production expanded by at least one-quarter
of one percent annually between 1645 and 1873.36 Given the slow growth of
population, output per person is believed to have increased throughout the period.
Since tax rates levied by the feudal leaders of Japan failed to rise, an increasing
share of agricultural output remained in the hands of the farmers themselves. The
increased production was often marketed instead of consumed and this resulted
in a growing degree of commercialization during the Tokugawa period. Some of
the increased production was also used to purchase nonagricultural goods, which
led to an expansion of markets for these goods. In those areas where this activity
was most intense farmers began devoting part of their time to the production of
such nonagricultural goods.37
This process accelerated with the Meiji Restoration. A backlog of agricultural
technology had accumulated during the Tokugawa period, but various feudal
obstacles to the diffusion of such knowledge had limited its spread. With the
restoration many of these obstacles were eliminated and knowledge of new seeds
and techniques utilized in specific regions spread throughout Japan. From 1880
to 1900, agricultural output grew at an annual rate of 1.6 percent, and from 1900
to 1920, at an annual rate of 2.0 percent. Almost all of this increase was the result
of productivity growth.38 Once again, much of this surplus productivity remained
within the agricultural sector itself. The government was unable to increase the
extraction of resources via taxation.
As incomes rose in the agricultural sector, markets for simple manufactured

goods, like textiles, grew rapidly. In 1880, most cotton yarn was imported into
Japan, and the total domestic demand for such yarn (domestic production for
domestic consumption plus imports) was 4,732 Kan (Kan = 8.278 pounds). By
1890, this amount had more than doubled to 10,136 Kan. By 1900, this figure had
gone up by three times to over 30,000 Kan.9 Thus, domestic demand grew very
rapidly during this time period.
Additional evidence concerning the rapidity of such growth can be gleaned
from a comparison of developments in the textile industry for India and Japan
during this time period. For example, in 1883 the ratio of the total number of
spindles employed in India relative to Japan was 65.1 to 1. By 1900, this ratio had
dramatically fallen to 4.7 to 1. In terms of pounds of production of yarn and twist,
the ratio of India to Japan in 1880 was 11.3 to 1. By 1900, it had fallen to 1.4 to
1. This is an indication of how rapidly the demand for textiles in Japan was
growing relative to that of India.40
The rapid growth of demand in Japan was accompanied by rapid technical
innovation in textile production as well. This innovation involved the importation
and adaptation of foreign technology. One of the most important examples of this
was the cotton-spinning process. In the 1 880s, initial efforts aimed at establishing
the cotton-spinning industry involved the use of the mule-spinning method,
which employed machinery able both to spin yarn and to wind it, but not
simultaneously. The process required skilled and heavy labor, but it did not
require high grade raw cotton.4'
Japanese producers quickly realized that the scarcity of skilled labor posed
significant problems in the utilization of the mule-spinning method. Thus in the
late 1 880s, Japanese mills began importing the ring-spinning technology. This
method could spin and wind yarn simultaneously and was much more labor
intensive. A major problem was that it required a very high quality raw cotton
input. Japanese spinners, however, were able to come up with methods of
utilizing the ring-spinning method "through the application of more labour to the
preparation of the cotton for spinning and, in particular, the mixing of high quality
and low quality material."42 This is but one example of how foreign technology
was imported and adapted to circumstances in Japan.
The end result of these developments was that Japanese exports of textiles
were able to capture a large share of the Asian market, while those of India, which
was slower to import and adapt foreign technology, fell steadily behind. Most
significant, from the viewpoint of this paper, the British kept nominal tariffs at
zero in India until the 1920s. This policy resulted in a rate of effective protection
for the Indian weaving and spinning industries of zero. Unequal treaties imposed
on Japan by the West also severely restricted the tariff rates that the Japanese
could levy. Positive rates of protection were provided, however, and with
increasing tariff autonomy the level of protection rose in the early part of the
twentieth century.43 The effective rates ofprotection were relatively modest when
compared to those imposed on production by today's developing nations. The
point is, however, that the Japanese textile industry was protected. Given the
rapid growth in the demand for cotton textiles in Japan, only a modest level of
protection was needed. Also, the gap between the best-practice technology
(frontier) and that utilized in Japan prior to 1868, although large, was relatively
modest in comparison with the gaps facing today's developing countries. Finally,
it should be noted that even in the case of a relatively labor-intensive industry,
such as textiles, Japan was unable to develop a comparative advantage without the
use of protection.
In summary, I would argue that in Japan the causality ran from agricultural
growth and rapid growth in demand to capable states and successful transition
from import substitution. For South Korea and Taiwan, the situation is more
complex. These countries were, prior to World War II, colonies of Japan. The
latter established a strong state apparatus that was capable of promoting rapid
growth in agricultural productivity. Thus, causation here would seem to run from
the strong state to rapid agricultural growth. I would argue, however, that in the
postwar period the dynamically progressive agricultural sector inherited from the
Japanese provided an environment hospitable to the development of a capable
state. That, however, is the subject of another paper.
Summary
The transition from import substitution to export-based growth is a difficult

one to make. Import substitution would seem to be a necessary step even in the
establishment and evolution of labor-intensive industries in developing countries.
This step is what allows entrepreneurs in such industries to import foreign
technology and innovatively adapt it to local circumstances. The results of
protecting such industries in most developing countries, however, have not been
encouraging. The industries have failed to rapidly close the technology gap and
have thus failed to become internationally competitive through cost reductions
and quality improvements.
The failure of most developing countries to make the transition to export-based
growth was related to the rate of growth of the domestic market. The faster this
takes place, the greater the degree of specialization and the larger the investment
in new equipment that will occur. Most important, there will be a more rapid
mastery of new technology. The growth in market size was in turn related to the
growth in agricultural productivity. Although there are circumstances where the
agricultural sector may not be the main source of domestic demand growth, for
most of today's developing nations this is not likely to be the case. Thus, a
dynamic agricultural sector would seem to be necessary to provide the conditions
for a successful transition.
A dynamic agricultural sector is important from another perspective. I argued
that it provides the foundation for effective and capable state activity. It does so
once again by generating a rapid growth in domestic demand for manufactured
goods. It is this fast growing demand that lends credibility to government threats
to withdraw subsidies for firms whose performance is poor. In addition, in an
economy in which the domestic market is rapidly growing, the amount of subsidy
that needs to be provided to infant industries is smaller. This tends to reduce the
degree of rent-seeking activity directed at the government by special interest

groups. This again strengthens the government's ability to carry out effective
economic policy.
The ideas presented in the paper were illustrated by reference to the development
of the Japanese textile industry. In this case, it was argued that the direction of
causality ran from agricultural growth, to growth of the domestic market, to
increased state capacity, to successful transformation to outward-oriented growth.
In other cases, the causality may run from a strong state to agricultural productivity.
Much of the developing world experience probably involves causality running in
both directions. This provides fertile areas for future research.
NOTES
1. For reference to this literature see Richard Luedde-Neurath, Import Controls and Export
Oriented Development: A Reassessment of the South Korean Case (Boulder, CO: Westview, 1986), p. 8.
2. For a general discussion of import substitution see Henry Bruton, "Import Substitution,"
inHandbookofDevelopment Economics, vol. 2, ed. Hollis Chenery and T. N. Srinivasan, (Amsterdam:
North Holland, 1988), pp. 1601-44.
3. For a simple discussion of these ideas see Jan Hogendorn, Economic Development (New
York: Harper Collins Publishers, 1992), pp. 486-97.
4. Peter H. Lindert, International Economics (Homewood, IL: Richard D. Irwin, 1993),
pp. 252-57.
5. See Raul Prebisch, The Economic Development of Latin America and Its Principal
Problems (New York: Economic Commission for Latin America, 1950).
6. W. ArthurLewis, "Economic Developmentwith Unlimited Supplies of Labour,"Manchester
School 22 (May 1954): 139-91.
7. This is described but not accepted by W. M. Corden, "The Normative Theory of
International Trade," in Handbook of International Economics: Volume 1, International Trade, e
Ronald W. Jones and Peter B. Kenen (New York: North Holland, 1984), p. 92.
8. Lindert, International Economics, p. 138.
9. Charles Wolf, Jr., "A Theory of Non-Market Failure: Framework for Implementation,"
Journal of Law and Economics 22 (April 1982): 107-39.
10. Anne 0. Krueger, "The Political Economy of the Rent-Seeking Society," American
Economic Review 64 (June 1974): 291-303.
11. Hodgendorn, Economic Development, p. 487.
12. Anne O. Krueger, "Trade Policy as an Input to Development,"American Economic Review
80 (May 1990): 288-92.
13. Deepak Lal and Sarath Rajapatirana, "Foreign Trade Regimes and Economic Growth in
Developing Countries," Research Observer 2 (July 1987): 208-11.
14. William Cline, "Can the East Asian Model of Development Be Generalized," World
Development 10 (February 1982): 81-90.
15. Douglass North,Institutions, Institutional Change, andEconomicPerformance (Cambridge:
Cambridge University Press, 1990), p. 43.
16. Howard Pack and Larry E. Westphal, "Industrial Strategy and Technological Change:
Theory versus Reality," Journal of Development Economics 22 (June 1986): 105.
17. Alice H. Amsden,Asia 'sNext Giant: South Korea andLate Industrialization (New York:
Oxford University Press, 1989), pp. 109-12.
18. Ibid., p. 1l1.
19. Amsden, Asia's Next Giant, p. 11 1.
20. Amsden, Asia's Next Giant, p. 111.
21. For additional discussion, see Alice H. Amsden, "The Division of Labour Is Limited by
the Rate of Growth of the Market: The Taiwan Machine Tool Industry in the 1970s," Cambridge
Journal of Economics 9 (September 1985): 271-84.
22. Luedde-Neurath, Import Controls and Export-Oriented Development, pp. 175-76.

23. Yuji Kubo, Jaime DeMelo, and Sherman Robinson, "Trade Strategies and Growth
Episodes," in Industrialization and Growth: A Comparative Study, ed. Hollis Chenery, Sherman
Robinson, and Moshe Syrquin (New York: Oxford University Press, 1986), pp. 148-87.
24. See Alice H. Amsden, "A Theory of Government Intervention in Late Industrialization,"
in State and Market in Development: Synergy or Rivalry, ed. Louis Putterman and Dietrich
Rueschemeyer (Boulder, CO: Lynne Rienner, 1992), pp. 53-84.
25. Bela Balassa, "Inward Oriented Strategies," inLeadingIssues in Economic Development,
ed. Gerald M. Meier (New York: Oxford University Press, 1989), p. 395.
26. Robert Baldwin, "Patterns of Development in Newly Settled Regions," Manchester
School 24 (May 1956): 161-79.
27. Douglass North, "Agriculture in Regional Economic Growth,"Journal ofFarm Economics
41 (December 1959): 943-51.
28. Kevin Murphy, Andrei Shleifer, and Robert Vishny, "Income Distribution, Market Size,
and Industrialization," Quarterly Journal of Economics (August 1989): 537-64.
29. Dieter Senghaas, The European Experience: A Historical Critique ofDevelopment Theory
(Dover, NH: Leamington Spa, 1985).
30. Amsden, "Theory of Government Intervention," p. 61.
32. North, Institutions, Institutional Change, and Economic Performance, p. 43.
34. The next several paragraphs are based on Richard Grabowski, "The Successful
Developmental State: Where Does It Come From?" World Development 22 (March 1994): 413-22.
35. For a general discussion of rent seeking, see Guido Ashoff, "Rent Seeking: A New
Concept in the Economic Theory of Politics and the Debate on Development Theory," Economics 40
(1989): 7-41.
36. Susan B. Hanley and Kozo Yamamura,Economic andDemographic Change in Preindustrial
Japan, 1600-1868 (Princeton, NJ: Princeton University Press, 1977), p. 20.
37. For a discussion of this commercialization process, see Thomas C. Smith, The Agrarian
Origins of Modern Japan (Stanford, CA: Stanford University Press, 1959).
38. Yujiro Hayami and Vernon Ruttan,AgriculturalDevelopment: An International Perspective
(Baltimore, MD: Johns Hopkins University Press, 1985), pp. 167 and 234-35.
39. Keijiro Otsuka, Gustav Ranis, and Gary Saxonhouse, Comparative Technology Choice in
Development: The Indian and Japanese Cotton Textile Industries (London: Macmillan Press, 1988),
pp. 28-29.
40. Otsuka, Ranis, and Saxonhouse, Comparative Technology Choice, pp. 5-20.
41. Penelope Francks, Japanese Economic Development: Theory and Practice (London:
Routledge, 1992), p. 184.
42. Francks, Japanese Economic Development, p. 184.
43. See Otsuka, Ranis, and Saxonhouse, Comparative Technology Choice.

Import Substitution, Export Promotion, and the Role of the State in Economic Development

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Import Substitution, Export Promotion, and the State in Economic Development

Author(s): Richard Grabowski

College of Business, Tennessee State University is collaborating with JSTOR to digitize,

Import Substitution, Export Promotion,

Development economics has been subject to significant shifts in viewpoint

Professor, Department of Economics, Southern Illinois University-Carbondale, Carbondale, IL

? 1994 by Western Illinois University. All rights reserved.

Import Substitution and Development

Import-substitution strategies of economic development have generally used

marginal product of labor in industry is equal to the wage rate, as determined in

Export-Based or Outward-Oriented Development

The export-based or outward-oriented strategy of development has been

Another possible dynamic impact of an outward-oriented strategy relates to

to particular circumstances without actually applying it. Thus the learning of a

An Alternative Perspective of Development Based on Technological

The Relationship between Market Growth and State Behavior

succeeding in the promotion of rapid productivity growth and eventually rapid

government punishes unproductive use of the subsidy by withdrawing it. If the

substitution or direct export subsidy, is likely to lead to powerful efforts by the

The Relationship between Market Growth and State Behavior: Japan

As incomes rose in the agricultural sector, markets for simple manufactured

The transition from import substitution to export-based growth is a difficult

degree of rent-seeking activity directed at the government by special interest

22. Luedde-Neurath, Import Controls and Export-Oriented Development, pp. 175-76.

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